Summary:

discounting methods
- PV
- FV
- PV (semi annual compounding)
- PV (continuous compounding)

Difference coupon rate and yield: coupon = yield => bond selling at par
Consols: perpetual bonds (regular coupons payments, no redemption dates)
1
Effect of change in yield value: use Taylor expansion 1 = 0 + (0 ) + 2 ()2

Effect on derivatives contract

Dollar Duration
Dollar value of a basis point (DVBP; DV01)
Dollar convexity

Banks:
- Commercial
o Retial
o Wholesale
- Investment

5. Markets:
- Exchange: define contracts that trade and organize trading so that market participants can
be sure that the trades they agree to will be honored. Traditionally: open outcry, now mostly
electronic trading
- Market makers: individual companies who are always prepared to quote both a bid price
(price at which they are prepared to buy) and an offer price ( price at which they are
prepared to sell.

- Over the counter: network of traders who work for financial institutions, large corporations
or fund managers. Used for trading many different products. Market participant are free to
negotiate any mutually attractive deal (not necessarily the ones specified in an exchange)
- Clearing houses: administer exchange traded derivatives contracts: allow buyer and seller
to trade only with the clearing house.
- margin: when trader has potential future liability, clearing house require trader to be able
to provide cash or marketable securities as collateral (= margin)

- Spot trades: lead to almost immediate delivery of asset

o Long
o Short: selling of an asset not owned (borrowed) with intention to repurchase
it later
Short squeezed: broker runs out of shares to borrow, forced to close
out position immediately
Investor wi
- Derivatives
 o Plain vanilla:
Futures
Froward
Swap
Options
Call option: give holder right to buy underlying asset by a
certain date at certain price
Put: give holder right to sell underlying asset by a certain date
at certain price
Exercise price/strike price: price in the contract
Expiration/maturity date:
European options: exercised only on expiration date itself
American options: exercised anytime up to expiration date
At the money option: strike price = price of underlying asset
Out of the money option: call option where strike price is
above underlying asset or call option is below underlying asset
In the money: call option where strike price is above
underlying asset price or put option where price is under
underlying price asset
o Non-traditional:
Weather options
Oil derivatives
Natural gas derivatives
Electricity dervatives
o Exotic options
o Structured products
- LIBOR

23. Operational Risk:

- Residual Definition: any risk faced by a financial institution that is not market risk or
credit risk
- Narrower definition: risk arising from operations
- Basel definition: risk of loss resulting form inadequate or failed internal processes,
people and systems, or from external events.
-
- Categories of operational risks:
o Internal Fraud:
o External Fraud
o Employment practice & workplace safety
o Clients, products and business practices
o Damages to physical assets
o Business disruption and system failures
o Execution, delivery and process management
- Internal Risks: companies over which the company has control
- Determination of regulatory capital:
 o Basic indicator approach: 15% of annual gross income over the previous 3
Years (gross income = net interest income + non interest income
o Standardized approach: division of banks activities in 8 business lines. The
average gross income over the last 3 years for each business line is multiplied
by a beta factor for that business line and the result summed to determine
the total capital.
o Advanced measurement approach (AMA)
- Loss frequency distribution: distribution on the number of losses observed during
one year. Poisson distribution
- Loss severity distribution: distribution of the size of a loss, given that a loss occurs.
Lognormal
- Linear combination of loss severity distribution and loss frequency distribution:
Monte Carlo simulation
- Implementation of AMA: measurement:
o Internal Data: for the moment, only few data available
o External Data
o Scenario Analysis
o Business environment and internal control factors
- Types of operational risk losses:
o High frequency low severity losses (HFLSLs): e.g. credit card fraud losses
o Low frequency high-severity losses (LFHSLs): e.g. rogue trader losses

CAPM:
- Assumption
- Market portfolio (M):
-

Statistics:
1.
Key statistical concepts
Expected return:
a. Definition: a probability-weighted average of an assets return in all
states (scenarios).

n b. Formula: E(R) = PR ,

ii i=1

Where i: states of nature Pi: probability of that the event will

happen in state i. Ri: the return of the asset if the event happens in
state i. c. Example: suppose an asset is priced at $100. There are
three possible
outcomes in one year: good, soso and bad.

Three possible outcomes (i):

Good 50% 25% $ 110 90 10% -10%

Soso Bad

Probability (Pi) Prices Return (Ri)

25% $ 120 20%

How do you calculate the average of a probability distribution?
Simply take the probability of each possible return outcome and
multiply it by the return outcome itself. E(R) = (0.5) (0.1) + (0.25)
(0.2) + (0.25) (-0.1) = 0.075= 7.5% Although this is what you expect
the return to be, there is no guarantee that it will be the actual return.
d. the rate of return on a portfolio is a weighted average of the
return of each asset comprising the portfolio, with portfolio
proportions as weights. This implies that the expected return on a
portfolio is a weighted average of the expected return on each
component asset.
For example, a portfolio with value of $200, which consists of $100
stock A and $100 stock B. E(rA) = 20%, E(rB) = 10%, E(expected
return of portfolio) = (100/200)*20% + (100/200)*10% = 15%
2. Variance (the second central moment):

a. Definition: A measure of the dispersion of a set of data points

around their mean value. It is the expected value of the
 squared deviations from the expected return. n

= Var(R) = P[R E(R)]2 Variance measures the

2
b. Formula:

ii i=1

variability (volatility) from an average. Volatility is a measure of

risk, so this statistic can help determine the risk an investor might
take on when purchasing a specific security.
2 2
c. Example: Var(R) = 0.25(0.2-0.075) + 0.5(0.1-0.075) + 0.25(-0.1-
2
0.075) = 1.19%
3. Standard deviation:

a. Definition: The square root of the variance. A measure of the

dispersion of a set of data from its mean. The more spread
apart the data is, the higher the deviation. In finance, standard
deviation is applied to the annual rate of return of an investment
to measure the investment's volatility (risk).

b. Formula: = Var(R)

c. Example: Standard deviation = Var(R) = 1.19% =10.90%

4. Covariance: a. Definition: A measure of the degree to which

returns on two risky
assets move in tandem. A positive covariance means that asset
returns move together. A negative covariance means returns vary
inversely.
b. Formula: Cov(RA ,RB ) =

A: Asset A.

i=1

P[R E(R )][R E(R )], where iiA AiB B

n

B: Asset B. If you owned one asset that had a high covariance with
another asset that you didn't own, then you would receive very little
increased diversification by adding the
- 14 -

Study notes of Bodie, Kane & Marcus By Zhipeng Yan

second asset. Of course, the opposite is true as well, adding assets

with low covariance to your portfolio lowers overall portfolio risk. c.
example: suppose two risky assets A and B:
Three possible outcomes (i): Good Soso Bad

Probability (Pi) Return of Asset A (RiA) Return of Asset B

(RiB) E(RA) = 7.5% E(RB) = 0% Cov(RA, RB) = 0.25(0.2-
0.075)(0.3-0)+ 0.5(0.1-0.075)(0-0) + 0.25(-0.1-0.075)(-0.3- 0) =
2.25%
5. Portfolios variance: when two risky assets with variance var1 and
var2, respectively, are combined into a portfolio with portfolio
weights w1 and w2, r e s p e c t i v e l y , t h e p o r t f o l i o v a r i a n
c e p2 i s g i v e n b y

2 =w22 +w22 +2ww cov(r,r) p11221111

A positive covariance increases portfolio variance, and a negative
covariance acts to reduce portfolio variance. If var1 = var2 = -
covariance and w1 and w2, then portfolios variance is zero (prove
it!) 6. Correlation coefficient: a statistical measure of how two
securities move in
relation to each other. It ranges between -1 and +1.
Cov(RA ,RB )
a. Formula: corr(RA ,RB ) = A B

b. Perfect positive correlation (a correlation co-efficient of +1)

implies that as one security moves, either up or down, the other
security will move in lockstep, in the same direction. Alternatively,
perfect negative correlation means that if one security moves in
either direction the security that is perfectly negatively correlated will
move by an equal amount in the opposite direction. If the correlation
is 0, the movements of the securities is said to have no correlation, it is
completely random. If one security moves up or down there is as good
a chance that the other will move either up or down, the way in which
they move is totally random.
In real life however you likely will not find perfectly correlated
securities, rather you will find securities with some degree of
correlation. For example, the performance of two stocks within the
same industry is strongly positively correlated although it may not be
exactly +1.
Correlation V.S.Covariance:

Basically, Correlation is better than covariance: 1 -- Because

correlation removes the effect of the variance of the variables, it
provides a standardized, absolute measure of the strength of the
relationship, bounded by -1.0 and 1.0. This is good because it makes it
25% 50% 25% 20% 10% -10% 30% 0% -30%

IV. 1.

Kurtosis: A statistical measure used to describe the distribution of

observed data around the mean. Used generally in the statistical field,
it describes trends in charts. A high kurtosis portrays a chart with fat
tails and a low even distribution, whereas a low kurtosis portrays a
chart with skinny tails and a distribution concentrated towards the
mean. It is sometimes referred to as the "volatility of volatility."

Appendix A Variance (the second central moment) does not provide

a full description of risk. Consider the two probability distributions for
rates of return on a portfolio, A and B. A and B are probability
distributions with identical expected values and variance. However, A
is characterized by more likely but small losses and less likely but
extreme gains. This pattern is reversed in B. the difference is
important. When we talk about risk, we really mean bad
surprises. The bad surprises in A, although they are more likely, are
small (and limited) in magnitude. The bad surprises in B, are more
likely to be extreme. A risk-averse
investor will prefer A to B. We use skewness to describe this
asymmetry.
possible to compare any correlation to any other correlation and see
which is stronger. You cannot do this with covariance. 2 -- The
squared correlation (r2) is a measure of how much of the variance in
one variable is explained by the other variable. This measure, the
coefficient of determination, ranges from 0.0 to 1.0. You cannot do
this with covariance.
7. Skewness (the third central moment): A statistical term used to
describe a situation's asymmetry in relation to a normal distribution. A
positive skew describes a distribution favoring the right tail, whereas a
negative skew describes a distribution favoring the left tail.
Formula: M = 3

i=1

P[R E(R)]3 ii
n
n M= P[RE(R)]3
3

i=1

ii

Cubing the deviations from the expected value preserves their signs,
which allows us to distinguish good from bad surprises. Because this
procedure gives greater weight to larger deviations, it causes the long
tail of the distribution to dominate the measure of skewness. Thus the
skewness of the distribution will be positive for a right-skewed
distribution such as A and negative for a left-skewed distribution such
as B.
2. To summarize, the first moment (expected value) represents
the reward. The second and higher central moments
characterize the uncertainty of the reward. All the even
moments (variance, M4, etc.) represent the likelihood of
extreme values. Larger values for these moments indicates
greater uncertainty. The odd moments (M3, M5, etc.)
represent measures of asymmetry. Positive numbers are
associated with positive skewness and hence are desirable.

3. We can write the utility value derived from the probability

distribution as: - 16 -

Study notes of Bodie, Kane & Marcus By Zhipeng Yan

U=E(r)b2+bM bM +bM ... 0 132435

Where the importance of the terms lessens as we proceed to higher
moments. Notice that the good (odd) moments have positive
coefficients, whereas the bad (even) moments have minus signs in
front of the coefficients. 4. Samuelson (1970, Review of Economic
Studies, 37) proves that in many
important circumstances:
a. The importance of all moments beyond the variance is much
smaller than that of the expected value and variance. In other
words, disregarding moments higher than the variance will not
affect portfolio choice.

b. The variance is as important as the mean to investor welfare.

Samuelsons proof is the major theoretical justification for mean-

variance analysis. Under the conditions of this proof mean and
variance are equally important, and we can overlook all other
moments without harm. 5. Modern portfolio theory, for the most
part, assumes that asset returns are
normally distributed, because the normal distribution can be
described completely by its mean and variance, consistent with
mean-variance analysis.